The consensus expectation among economists is for the annual headline rate to fall to 3.1% in June for its lowest level since March 2021, compared to 4% in May.


The release looks set to provide further evidence that the COVID-19 related supply chain disruptions and rising energy prices that fueled much of the inflation spike in 2021 and 2022 are continuing to fade.


But we believe the Fed will not yet be willing to declare victory on inflation, and risks remain that equity investors will face disappointment over the economic outlook.


Core inflation, a better measure of underlying price pressures, remains well above the Fed's target. Economists are expecting the core consumer price index annual reading to fall to 5% in June, from 5.3% in May. That would continue the steady decline since the 6.6% peak reached in October 2022. However, it is still some distance from being consistent with the Fed’s target. Investors will also be looking for confirmation of the falling trend from the Fed’s preferred inflation metric, the core personal consumption expenditure index, which has been fluctuating between 4.6% and 4.7% so far this year and shown no marked downward trend in 2023.


The service sector has remained a driver of inflation so far. Inflation has already been vanquished in parts of the economy, with consumer durable goods prices falling since December. The Fed’s main area of concern has been on the strength of the services sector, where annual inflation was still 6.3%in May. In certain areas of the services sector, demand has become less price-elastic since the pandemic, meaning that consumers have been reluctant to curtail spending in this area despite higher prices, especially on vacations.


Even excluding owners’ equivalent rent—which calculates the price that homeowners would need to pay in order to rent their own property—services inflation was still 4.2% year-on-year in May. Data on new rental contracts suggests this will slow further over the coming months. But the Fed will want to see confirmation. Meanwhile, the ISM services index continued to point to service sector strength for June, with a rebound to a four-month high of 53.9, compared to a consensus forecast of 51.2.


The labor market remains too strong for comfort. There have been some positive signals recently that demand for workers is easing in the latest releases, which would support hopes for an imminent end to Fed tightening. The payroll data for June pointed to the smallest monthly gain in employment since December 2020. It was also the first reading not to top the consensus forecast, following 14 consecutive months of above-expectations readings. However, the jobless rate fell back to 3.6%, from 3.7%, still close to April’s 3.4%, which matched a 69-year low. Meanwhile, average hourly earnings—both monthly and annually—exceeded expectations, and wage growth is too rapid to be compatible with the Fed’s 2% inflation target.


So, overall, we continue to expect inflation to trend lower. Regional differences, with inflation running below 3% in cities like Los Angeles, provide reassurance that price pressures are less sticky than some investors might fear and can come down as the economy cools. However, we still believe the equity market is pricing in too much good news on inflation and the economic outlook more broadly. As a result, we are least preferred on equities versus fixed income. In addition, given the risk that the Fed will permit inflation to remain modestly above target for some time, we see value in real assets like infrastructure, commodities, and select core real estate. Such assets could help with long-term inflation mitigation, and provide portfolio diversification along with income.


Main contributors - Solita Marcelli, Mark Haefele, Christopher Swann, Paul Donovan, Vincent Heaney, Jon Gordon


Original report - Markets brace for US inflation data, 12 July 2023.